Market Makers Gunning for Retail Investors

NEW YORK (TheStreet) -- Urged by Wall Street insiders, the SEC is considering a rule change that will increase market maker profits at the expense of retail investors. Citigroup (C), J.P. Morgan (JPM), Goldman Sachs (GS), Merrill Lynch (MER), Morgan Stanley (MS) and others stand to profit. Citigroup has submitted a letter to the SEC supporting a pilot program.

To fully understand how rule changes could impact the market, it's helpful to understand how markets evolved. In 1982, we saw the first 100-million-share day of trading volume, and I still remember the front page headline announcing the historic event. Ten years later, 200 million shares traded in a single day for the first time.

Oh yes, the "good old days", when investors paid exorbitant commissions and were forced to buy at the offer and sell at the bid with typical spreads of 1/8 (12.5 cents). Between the stockbrokers, market makers and specialists each taking their pound of flesh. A 1,000 share order could cost upwards of $200.

A specialist at the NYSE (ICE) had a de facto license to print money, and investors had to pay to play. A look at the lifestyles of Wall Street specialists and market makers suggest they made out much better than most retail investors.

It was a fantastic gig (for the insiders) while it lasted, but alternative markets and new technology introduced competition for the first time, increasing efficiency and driving costs lower.

Transaction commissions dropping from $40 to $4 saved investors significant amounts of money. The greatest efficiency and savings came when the SEC required a level playing field allowing everyone (including retail investors) to display a bid or ask that anyone else could transact with.

Without the SEC protecting their monopoly, market makers and specialists could no longer extort their middleman cut from every trade, causing spreads and transaction costs to collapse. Instead of paying an oversized market maker spreads, investors themselves became the market.

Unmolested by market makers, investors enthusiastically welcomed the new market efficiencies and trading volume surged from millions to billions of shares a day.

Let's examine the total cost of two transactions. Example one, you purchase 1,000 shares in a stock with a penny spread (bid $10 and ask $10.01). You could post a bid for $10 and hope someone else will "hit" your bid, resulting in a cost of $1,000. Your other choice is to pay the spread, and your total cost is $1,010. Not a substantial difference; that's the power of having a level playing field.

In the second example, the SEC limits retail investors (but not market makers) to bid or ask increments of 10 cents. The spread is now bid $10 and offering $10.10. The result is you're still allowed to bid $10, but you will only get filled if the market "moves through you" (offer falls below your bid).

Investors quickly realize they are in a no win situation and pay the SEC-required spread to the market maker. Your total cost as a result of a minimum 10-cent spread is $1,100, instead of $1,010. The spread, not commissions, play the larger influence in your investment results.

You won't get an order fill because market makers and brokers offer "price improvement" of one-tenth of a cent, resulting in trades near $10.011 while your bid sits there unexecuted.

Sub-penny transaction pricing is designed to place retail investors at a competitive disadvantage compared to Wall Street insiders. Retail investors aren't allowed to trade in less-than-a-penny increments. Insiders figured out if they could get the SEC to prohibit retail investors from offering as small of increments as them, they could "front-run" retail orders by only paying one-tenth of a penny difference.

The idea was sold to the SEC by calling it "price improvement", but don't kid yourself, market makers and insiders aren't looking out for retail investors (if you believe they are, I have ocean-front property in Wisconsin for sale), they wanted order priority, and the SEC gave the green light to jump in front of retail investors by paying just a fraction of a penny.

Retail investors were no longer on a level playing field once the SEC gave the green light to jump in front of retail investors by paying just a fraction of a penny. But that's not enough. What market makers genuinely want is to go back to when they could extract a little blood from each investor for every transaction. By combining the ability to jump in front of retail investors with a sub-penny price "improvement" and a minimum 5 or 10 cent spread, the de facto result will be a return to retail traders who are no longer able to cut out the middleman and will have to pay a "fee" to market makers.

Of course, market makers can't simply say they want to extract more flesh from retail investors, so they came up with a different sales pitch. They're claiming that lower volume stocks will gain increased investor interest if the SEC will forbid retail traders from posting bids/offers in penny increments.

They like to argue that a low-volume stock's volatility will decrease if retail traders are disadvantaged, but the proposal isn't a maximum spread; it's a minimum spread. The market already determines an appropriate amount between the bid and offer for any given stock at any given time.

History clearly demonstrates that placing some market participants at a disadvantage results in lower participation. All else being equal, smart money will avoid allocating capital where they have the worst of it.

After specialists and market makers lost their SEC sanctioned middleman, monopoly trading volume and liquidity exploded higher. An example we can examine today is options. Unlike equity options, retail investors/traders are on a level playing field futures options. Even with lower volume, futures option spreads are typically relatively smaller than equity options.
 
Retail investors are not allowed to have bids and offers posted at the same time, resulting in a de facto requirement that retail accounts must transact with and pay a larger-than-need-be spread to market makers on all but the highest volume contracts. Even stocks that trade over a million shares a day typically have large option spreads and low trading volume.

Low-volume stocks typically have larger spreads than higher-volume stocks. But that's not the point. It's not about creating a larger spread; it creates a larger advantage over retail accounts.

Smart investors can cash in if the SEC stacks the deck in favor of insiders by investing in a market-making firm. If a rule change is successful (meaning market makers are making a lot of money from it), you may want to consider shares in one or more of the market makers. The publicly traded market makers I reviewed are also involved in financial services, so it's difficult to gain direct exposure, but at least there is a consolation prize available.

At the time of publication, Weinstein had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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